QUARTERLY MARKET UPDATE July, 2014
ASSET CLASS PERFORMANCE Equity Markets - Consistent with the first three months of the year, major U.S. equity indices were able to record positive gains in the second quarter of 2014. The S&P 500 Index and more value oriented stocks outperformed the small caps, the Nasdaq Composite, and more growth oriented names. The Dow Jones Industrial Average climbed out of negative territory, though is still the laggard index year-to-date. Developed international equities, as measures by the MSCI EAFE Index, exhibited strength on a U.S. dollar basis. Adding on to solid results in May, emerging markets, which struggled in 2013 continued to outperform in the second quarter of 2014.
Fixed Income Markets - After a tough year in 2013, the broad fixed income sectors continued to turn in better results in the second quarter of this year. Corporate bonds, both investment grade and high yield, exhibited persistent strength, with emerging market debt (similar to their equity counterparts) posting even better results. The more interest rate sensitive sectors, most notably TIPS, recorded positive results for the quarter despite modest declines in April. Higher starting yield levels, questions surrounding the breadth of economic strength and mild inflation expectations have helped most fixed income sectors continue to recover since the beginning of the year.
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CAPITAL MARKETS OVERVIEW Key Economic Theme - Muted Inflation Expectations and Increased Treasury Strength While inflation is increasing (very gradually), inflation expectations are not.
Forward Inflation Expectations
Entering the year the consensus view maintained that the US economy would be gathering strength, such that Gross Domestic Product (GDP) growth of 3.0% or higher would again be exhibited. With two quarters down, that view seems questionable. First quarter GDP growth initially registered 0.1%; conjecture surmising the likelihood of adjustments showing a contraction in economic activity proved accurate, with a final revision registering a remarkable -2.9%. Still, there remains a drumbeat of optimism that potential growth will be reached this year as employment levels increase and capital spending accelerates. It’s an encouraged view, yet all capital markets don’t yet seem convinced of it. In addition to signals contrary to growth such as the drop in yield in longer-dated Treasury securities and the decline in lumber and copper prices, the spread between nominal and Treasury Inflation Protected Securities (TIPS) - a barometer of inflation expectations - can be also added to the list. This figure supports the more widely used Bureau of Labor Statistics’ Consumer Price Index (CPI), which also indicate that current inflation expectations remain historically muted. With the inclusion of the May report, CPI is now up 2.1% over the last 12 months while core CPI, which excludes food and energy, is up 2.0%. According to these measures there is no abject fear that inflation will become onerous over the next five years. The United States Federal Reserve (Fed) maintains a longer-run inflation target of 2.0% which it bases on the Personal Consumption Expenditure (PCE) price index, one that allows for generic pricing substitutes and places less weight on shelter costs than the CPI report does. On a year-over-year basis, the PCE price index shows inflation trends for total PCE and core PCE that are still running well below the Fed’s longer-run inflation target. Total PCE currently sits at 1.77% versus 1.69% at the end of 2013, and still remains below the average year-over-year CPI rate of 2.4% for the last 20 years. Further, the same can be said for the view of inflation in the five-year period starting five years from now. The so-called 5-yr forward 5-yr breakeven rate has dropped from 2.77% at the end of 2013 to 2.50% today. That basically means inflation is expected to be roughly 2.5% annually in the five-year period starting five years from now. Ultimately the market has maintained its faith in the Fed’s effort to promote longer-term price stability.
QUARTERLY MARKET UPDATE July, 2014 | Page Three There have been various explanations offered as to why longer-dated Treasuries (and other fixed income security classes) have done as well as they have this year. One explanation - and the most provocative one - is that this asset class forecasts economic activity that will not meet the heightened expectations of 3.0% GDP growth for 2014. It would be easier to dismiss that explanation if inflation expectations were ramping up, because higher levels of inflation are usually coincident with strengthening economic growth. What is evident today, though, is that market participants don’t fear a significant escalation in inflation anytime soon. Of course, a few additional stronger-than-expected CPI and employment reports could change that, but for now bond market pricing implies an outlook for mostly more of the same on the economic front: growth beneath potential and inflation rates below their long-term average.
PORTFOLIO IMPACT - Traditional Assets
PORTFOLIO IMPACT - Alternative Assets
Stocks – Given the conflicting growth signals from the macro data both domestically and internationally, investors have witnessed a change in sector leadership from cyclical sectors like industrials, materials and technology to later stage cycle/defensive sectors such as utilities, healthcare and energy. While all sectors enjoy positive year-to-date results in the markets unrelenting advance, this change in leadership and weakening of breadth indicate potential temporary restraint in this five year old bull market. Our sector positioning remains consistent with this outlook, as we remain overweight healthcare, infrastructure, telecom and other yield generating equity sectors.
Global Macro - The Global Macro strategy is designed to utilize traditional asset classes such a stocks, bonds and currencies in a manner that generates solid risk adjusted returns with low to negative correlations to those asset classes. These portfolios can short assets they deem unfavorable, or hold those they think have solid return potential. Current positioning’s including currency exposure to the Indian Rupee (implemented last August) and the increasing currency exposure to the Indonesian Rupiah since the beginning of the year. This portfolio has held off adding exposure to the Brazilian Real and they executed an options strategy to take advantage of the volatility in the Turkish Equity market in May, not placing a directional bet either way. They are currently short the South African equity market.
Bonds – All fixed income sectors have enjoyed positive year-to-date performance. However, the previous paragraphs regarding growth and inflation expectation notwithstanding, we recognize the historically low current yields and richly priced nature of bonds. As such, while we think bonds remain a crucial diversifier and will generate positive returns over the intermediate term, we acknowledge the existence of interest rate risk in our fixed income position. We therefore are predisposed to short duration corporates (we have extremely limited Treasury exposure), favoring credit risk over interest rate risk. The goal is to garner stable risk adjusted returns, even if long dated bonds could outperform in the near term due to the uncertainty of the macro environment
Absolute Return – The Absolute Return strategy is a multi-strategy core hedge fund allocation that seeks to improve the risk/return profile of a portfolio. As the Fed continues to taper its asset buying program, the credit long/short sub advisers remain focused on hedging duration risk by buying floating rate bank debt, buying high yield bonds with short duration, and shorting high yield bonds with long duration. In the Asset Backed (ABS) allocation, prices continue to grind higher on the back of continued improvements to fundamentals. The ABS sub-adviser remains overweight Commercial Mortgage Backed Securities (CMBS) relative to Residential Mortgage Backed Securities RMBS as the upside potential there is perceived to be more attractive.
Copyright © 2014 Kern DeWenter Viere, Ltd. All Rights Reserved. Investment advisory services and fee-based planning offered through KDV Wealth Management, LLC, an SEC Registered Investment Advisor.
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Copyright Š 2013 Kern DeWenter Viere, Ltd. All Rights Reserved. Investment advisory services and fee-based planning offered through KDV Wealth Management, LLC, an SEC Registered Investment Advisor. Securities offered through ValMark Securities, Inc. Member FINRA, SIPC - 130 Springside Drive, Suite 300, Akron, Ohio 44333-2431, 1-800-765-5201. KDV Wealth Management, LLC, is a separate entity from ValMark Securities, Inc. and ValMark Advisers, Inc.